We often about hear the role that venture capitalists play in fueling start-ups. But we all know they place their bets on just a handful of companies. So where do all those other entrepreneurs turn for capital? Savings, friends, and relatives, sure. But from all reports, it seems the deepest pockets belong to other entrepreneurs -- the adventur e capitalists. Let's find out how they go about doing deals.

-- E.C.

Tom Sears couldn't believe he'd stayed up most of the night for this. Rejected by bankers, venture capitalists, and even friends, here he stood red-eyed and rumpled in front of his last hope: five guys who looked more interested in their next tee-time than shelling out $300,000 to help his company.

When Sears proudly passed out his business plan for an educational software company, no one even flipped to the first page. While one potential investor sculpted his scrambled eggs, another scratched notes on the back of his green paper place mat. At the far end of the table, still another discussed the pros and cons of caffeinated coffee with the waitress.

Standing next to the wall of golf trophies at this country club in the New Hampshire hills, Sears yearned for the trappings of high finance: the gleaming skyscrapers, the oak-paneled boardrooms, the high-gloss presentations. Still, he pressed on, pointing to his 10-year reputation in the industry, his exclusive contracts, the relative vacuum in the market niche he had identified. But he thought he had lost them. No one seemed to be listening.

Sears slumped back in his chair and waited. He had barely lifted his cup of coffee when the questions came rapid-fire -- questions that were precise, penetrating, and to the point. Why would students switch to this product? How much of the design is proprietary? How will quality control be assured? How complex is the programming? Sears was stunned. Their informality belied the intelligence of these investors, and he quickly began to think maybe he was in the right place after all.

Such is the impression left on most newcomers to "the breakfast club," the Hollywood-inspired moniker for this group of middle-aged entrepreneurs who meet for breakfast about seven times a year to hear presentations, hash over business plans, and decide which start-ups to back with their time, energy, and capital.

Individually, these investors don't merit a blip on any chart of total investment capital in this country. Collectively, however, in cities and towns across the country, hundreds of thousands of similar investors -- successful entrepreneurs who are willing to invest in other entrepreneurs -- have quietly become the nation's major source of start-up capital, far outpacing the venture capitalists who grab the headlines.

Professional venture capitalists are expected to invest only about $1 billion this year in seed financing. Because start-up investments from the likes of the breakfast club are informal, scattered, and rarely talked about openly, solid numbers are hard to come by. One person who tried was Robert Gaston, commissioned to do a study by the Small Business Administration. The study (later published by John Wiley as Finding Private Venture Capital for Your Firm) put the total at $27 billion a year. While people may quibble about the exact figure, there is no question that the entrepreneur-turned-investor has become an extraordinary economic force.

These individual investors -- nicknamed "business angels," an apt description given their inclination to invest where others fear to tread -- typically provide their personal capital to the high-risk, early-stage deal and help the entrepreneur get started. While the power of angel capital grabs the spotlight when business icons like H. Ross Perot, the billionaire Texas industrialist, invests $20 million in the latest venture of Steven P. Jobs, most business angels operate far from the spotlight and lack even the informal structure of the breakfast club. Preferring instead to work alone, they find investments through friends, casual conversations, and referrals.

It's not a new phenomenon, of course. Henry Ford's auto empire was launched thanks to five angels who plunked down about $40,000 in 1903. What's changed is the power of this capital both in terms of numbers and the need it answers. In the past 20 years new incorporations skyrocketed almost 200%, and in step with this burst of new companies is the growth in the number of entrepreneurs who are angel candidates. In particular, start-ups from the high-tech boom of the 1970s have come of age, unleashing the wealth of founders who are eager to invest in the next generation. At the same time, start-ups gobble more dollars than ever before, making it less likely that founders can make do with back-pocket savings. Not only are there multiple markets to consider, but inflation and the rise in the value of the dollar both add to today's start-up costs.

Yet as much as venture capitalists agree that start-ups are costing more, they shy away from these riskier, untried waters. It's not because the venture money isn't there, however. In the last 10 years the venture pool multiplied 10 times, with about $32 billion invested by the end of 1988. Of the $3 billion invested in 1988 alone, nearly 50% went to later-stage deals and 19% to leveraged buyouts and acquisitions. Only 32%, or about $1 billion, went to early-stage deals. By venture capital definitions, these seed investments average about $800,000 to $1 million, much more than many start-ups need or want.

For angels, this spells opportunity. Record numbers of them stand ready to embrace would-be company founders, relishing the aura of uncertainty they themselves remember from the early days of their own ventures. The notion is a romantic one: entrepreneur begetting entrepreneur, one generation fueling the next. Sounds wonderful. And often it is. But an angel deal supposes that two strong egos -- the kind it takes to build a company and disprove all the naysayers -- can work side by side, sharing ideas and compromising when necessary. It's inevitable that on occasion, egos clash, angel takes on entrepreneur, and a bitter fight over the company ensues.

* * *

The New Hampshire breakfast club first began meeting three years ago, but their friendships and business deals extend back as long as 25 years. Members include Douglas Drane, a founder of Atex, the $60-million publishing computer-systems company acquired by Eastman Kodak Co. in 1988; George Schwenk, a founder of the INC. 500 company Termiflex, a manufacturer of hand-held computer terminals, and an investor in three other INC. 500 companies; Mort Goulder, a founder of Sanders Associates, now a $1-billion division of Lockheed that builds advanced electronic systems; and Dick Morley, founder of Modicon, a $250-million company that builds programmable controllers. All have since moved on to other ventures.

For these angels, nurturing start-ups is "a thrilling hobby," but one that plays second fiddle to the full-time job of running their own companies. Angel work squeezes into the spare moments -- an early-morning breakfast, a midafternoon rendezvous in a parking lot, or a late-night session after work. While individual members may receive a business plan every week, as a group they review only about seven companies a year and probably add no more than two to their portfolio. Each member analyzes a different angle. Schwenk, for example, dissects the financials, while Morley burrows into the technological questions. Sometimes all of them invest in a deal, and other times just a few chip in. On average, a member's initial investment in a company is $35,000.

Characteristic of most angels, the breakfast club prefers a deal within driving distance, so they can drop in easily. Moreover, deals tend to mirror the club's area of expertise in engineering and software. This is not ironclad, though. They have strayed into a Thai restaurant and children's furniture. "The only rule in this game is that there are no rules," Morley explains.

If Tom Sears convinces the breakfast club to invest -- and several members are still pondering that possibility -- what might he expect? Continued informality, of course. But a glimpse inside the workings of another breakfast-club deal reveals that this informality is served up with the kind of critical business judgment so important to a fledgling entrepreneur.

* * *

Marc Holtzman didn't think he could stand one more rejection. In nine months he'd made his pitch to 30 venture firms. The refrain became familiar: good idea but, well, maybe later. After three years working out of his basement and drawing no salary, a local venture capitalist hooked him up with the breakfast club.

George Schwenk remembers when he first read Holtzman's plan. "I couldn't even understand the product the guy was selling, but something, I can't explain what exactly, captured my imagination." The next day Schwenk arranged a time to meet Holtzman. Holtzman had no prototype, only an idea. For two hours he sketched wildly on a pad of paper giving form to a device that would automate the sample-preparation stage in biochemical research laboratories, a device that may be applicable in AIDS research. As the meeting drew to a close, Schwenk offered little commitment except a promise that he would call Holtzman in a week.

So began a six-week courtship, as Schwenk pondered the merits of both the investment and the person. They chatted over coffee, sometimes with a spreadsheet in front of them, and Schwenk would talk of his own company-building experience. Finally, Schwenk told Holtzman it was time to meet his fellow breakfast-club members.

At eight o'clock on a crisp November morning, Holtzman stood up in front of the breakfast club and defended his dream. That afternoon Holtzman phoned Schwenk asking how he'd done. Schwenk's response: "It went as well as it ever does, but the guys were concerned that your briefcase was too fancy."

In mid-December, Schwenk handed Holtzman two five-by-seven-inch index cards; scribbled on them was a blueprint for the future. One card laid out the incorporation of Holtzman's company, Cardinal Instruments Inc., and the issue of common stock, 75% owned by Holtzman and 25% owned by the breakfast club. Holtzman's percentage factored in his sweat equity and the $10,000 he'd spent so far on the project.

The second card sketched rough plans for the financial structure. Round I: the initial investment called for $60,000 from the breakfast club in exchange for the 25% equity interest, with the money devoted to developing a prototype. Round II: $300,000 garnered from a small venture firm that the breakfast club would bring in; the proceeds would go toward manufacturing the product. During this stage, the company would also look for about $250,000 in debt financing. Round III: an equity investment of about $1 million would be made by venture firms to roll out the product nationally.

While many angels structure deals combining guaranteed loans or debt financing, the breakfast club prefers the simplicity of common stock. "We're stacking the decks to optimize the company's chance at success," one member says, "not our recovery in the event of failure." That's not to say that angel work doesn't have its limits. With the investing clout of approximately $300,000 a year, the breakfast club eases out when the company is at the third or fourth financing. "We only pour a gallon of gas in the carburetor and get it off and going," a club member explains.

Once the company is chugging along, it's time to find more formal sources of capital with deeper pockets. The breakfast club works with six area venture firms -- all of which are run by either business associates or friends. "We know these firms are not intent on ripping the company from its founder," Schwenk says. And from the venture company's point of view, deals that come from the angels are prescreened.

Schwenk doesn't know when he'll pull out of Holtzman's company, although he says he "tends to tire after 15 years." Some club members envision a 5- to 7-year horizon, while others say they're in no rush. And when the time comes, the means of exit may vary from orchestrating an acquisition to taking the company public.

The breakfast-club members have never conducted a rigorous analysis of the return on their investments, but on average the group prefers deals with the look of a 20% return. Which isn't to say they always win -- they fondly refer to their losers as "the living dead." And as much as the breakfast club shuns rigid rules, there is one edict strictly enforced: no one -- not the breakfast club, not the venture capitalists, not even the founder -- shall be in a position to take control. "We don't run the risk of anyone getting wild-eyed and ruining the company," Schwenk explains.

* * *

Richard Sears couldn't disagree more. He doesn't know Schwenk -- Sears lives across the country in Lake Oswego, Ore. -- but he too is a business angel, one who insists that gaining control of a company is his only edge. Before putting his money on the line for Grandma Pfeiffer's Cakes-in-a-Jar, which is just what its name implies, he told the founder that he would be the one in charge. To him, this arrangement fit the investment. "What I offer isn't money; it's my expertise," Sears says. "The only way I can leverage my expertise is to be here every day, in the thick of it, in control."

Linda Pfeiffer, the founder of Grandma Pfeiffer's Products Inc., admits that giving way to Sears was difficult. But, she also admits, she had little choice. While she may have been in charge of the company on paper, in reality it was careering out of control. Her product, cakes baked in jars with a shelf life of almost two years, grew from zero to $250,000 in sales in two years, but costs were spiraling much faster than revenues.

"I had no partners to share my frustrations with, and I was running the business on a credit card," she remembers. "I'd been sleeping on the warehouse floor, and my marriage was crumbling."

An unlikely duo, Pfeiffer and Sears first met in February 1988 when Pfeiffer signed up for an entrepreneurship course taught by Sears. An engineer, Sears had launched several companies; his latest manufactured infrared imaging systems before he cashed out at the age of 40 for "a seven-figure sum." After traveling around the world for more than a year, Sears grew bored and decided to try his hand teaching budding entrepreneurs what he'd learned. Early on, Sears remembers noticing one student's keen understanding of her customer. "Linda didn't depend on the word of others," Sears marvels. "She spent weeks on the road meeting her customers, talking to them, and asking them questions herself."

What started as a student-teacher relationship quickly moved beyond hypothetical casebook exercises. After class Pfeiffer grilled her professor. Should she take a contract from one of the country's largest food companies? What if she couldn't meet its demands? How should she manage a new-product introduction? Sears was intrigued. Sure, selling cakes was a far cry from radar systems, but manufacturing was manufacturing, he reasoned.

Six months later Sears offered to invest about $150,000: $15,000 in equity and $75,000 in debt with a verbal agreement to kick in more after the first year. On his lawyer's advice, Sears formed another company, Grandma Pfeiffer's Inc., to acquire the assets of Pfeiffer's company, hoping to avoid any contingent liabilities. With that investment, Sears owned 80% of the company and installed himself as president. But as Sears will tell you, he didn't wake up one morning transformed into a business angel. "It's a huge personal risk to plunk down your money on someone else's dream; it's something you grow into," he explains.

Acting alone, without the benefit of a network like the breakfast club, Sears does a lot of legwork before investing. For example, he spent three months at trade shows selling Pfeiffer's cakes at the company's booth, gauging customer demand for himself before taking a stake in the company. He also advises two other entrepreneurs, but after almost a year of talking, he still hasn't put down a cent. "What makes these investments work," he says, "is a trust that only comes with time."

One look at the offices of Sears and Pfeiffer tells all you need to know about this partnership. With a high-tech white decor and clean surfaces, Sears's stylized office speaks of organization and efficiency. Just next door, Pfeiffer's office has a style she describes as more akin to a "playpen," with papers strewn everywhere and life-size color pinups of Mickey and Minnie Mouse decorating the walls. While Pfeiffer conjures up new twists on old cake recipes, alternate sales approaches, and creative marketing tactics, Sears talks of cost of goods sold, product specifications, and financing agreements.

Sears feels it's his job to yank Pfeiffer "out of the engine room and teach her how to navigate." When food giants such as Hershey's came knocking on the door with offers of large contracts, Sears urged Pfeiffer to at least go to the negotiating table, despite her mixed feelings. Before a meeting with a giant baking company, he prepped her, outlining all the likely questions, and during the meeting, the two sat side by side, taking turns answering questions.

Through all this has emerged a friendship beyond the financial partnership. "When the stress of the business broke my marriage apart, Richard and his wife were the only people who understood me, the business -- everything," Pfeiffer says.

This is not to say, however, that these two don't disagree. "Sometimes he wins; sometimes I win," Pfeiffer grins. Sears wants to do focus groups, but Pfeiffer vehemently opposes the plan, certain that it's too early. "I prefer to pop into his office with a new idea and just talk it out," she adds, "but he thinks it's time to put more communications in writing." What pulls it all together is respect. As much as Pfeiffer applauds her angel's business acumen, Sears bows to her marketing prowess.

In two to three years Sears intends to be out of his management role at the company and expects at least a 20% return on his investment if all goes well. Each year, assuming Pfeiffer meets her sales projections, she earns back a percentage of the company. "This is patient money," Sears says. "In an angel deal, you've got to be more patient than with your own company. It's hard," he continues. "I can see the snowballs coming down the mountain, but I can't tell her about all the problems, or I run the risk of squelching her fire, her excitement, and that's all that keeps this company going. This is her company; without her fire it fizzles."

How do prospective entrepreneurs go about finding sources of adventure capital? There's no sure answer to that question. Angels' services aren't listed in the Yellow Pages, and many prefer to keep their investment interests private. As one of the breakfast-club members puts it, the elusive nature of the angel is a necessary hurdle, separating the determined company builder from the not-so-determined one. "If an entrepreneur isn't willing to turn over every rock to find capital, then I don't want to meet him," he scoffs. Often angels are leaders both in their industry and in their community. They're men and women who've successfully built a company and, rather than retire with their riches, want to pump their money into the future.

Still, whatever the generalities about adventure capitalists, exceptions abound. Many are in the game for the thrills as much as for the cash return. Others have altruistic motives. William Mays, for example, an Indiana-based angel, puts his dollars only into minority-run start-ups. As a member of a minority group himself, Mays believes these founders crave the guidance of someone who's been there -- like himself. To break through any pretension, Mays often meets his founders in the sauna. "I want them to relax so they feel comfortable telling me the bad news," he explains.

Another angel, Douglas Van Zee, of Canton, S. Dak., not only looks for deals within his own industry, he narrows it down to his own $2.5 million company. So far, he's financed three employees, doing for them what was done for him 11 years ago when his boss forked over $25,000 to help launch Van Zee's grocery store. What's more, Van Zee says, investing in trusted employees lessens the need for lengthy, costly due-diligence proceedings.

Unlike Mays or Van Zee, many angels can't explain why they do what they do. It's like an addiction, they insist. It's uncontrollable. One member of the breakfast club compares his motivation to that of a motorcycle racer he knows. After breaking every bone in his body racing motorcycles, his friend still can't get away from racing. No longer in the driver's seat, this racer now coaches young riders. "We're playing the same game," the angel claim